The economic support for antitrust
has always been that monopoly practices are socially harmful because
they decrease total surplus. There is disagreement over whether
economic efficiency is now or ever was the goal of antitrust,
and there are scores of disagreements about exactly what practices
result in monopoly inefficiencies. But where the economic
rationale for antitrust is considered, that rationale invariably
has to do with welfare losses that follow from behavior that is
somehow related to restricted outputs and elevated prices.

But a new concern has recently arisen.
It was raised in the White Paper that became a part of the antitrust
action against Microsoft; it seems to be an active issue in the
Justice Department; and it has become a significant theme in the
economic literature of industrial organization. The issue can
be stated as follows: Are there systematic tendencies for inefficient
technologies to become established and resist replacement by superior
alternatives? For example, do we drive cars with the wrong type
of engines? Do we use the wrong type of nuclear reactors, improperly
designed typewriter keyboards, an inferior VCR format, and a backwards
computer operating system? If so, should these potential problems
be the focus of antitrust? In particular, are there forms of business
conduct that facilitate either premature commitment to inferior
technologies or the maintenance of their incumbency?

Some analysts in the literature
have argued that the answer to these questions is yes. The theoretical
support comes from economic models of "path dependence"
and "network externality." If this view is accepted
as an appropriate concern for antitrust, it would have far-reaching
implications. The problem shifts from monopoly versus competition
to the choice of one monopoly over another. The problem for antitrust
shifts from avoiding monopoly price elevation to choosing among
alternative technologies.

The theories of path dependence
and network externality are increasingly popular and have migrated
from the realm of economic theory to policy. Microsoft's conduct
in establishing standards has been the source of alarm in some
circles, prompting hyperbole to the point that Microsoft's influence
has been alleged to pose a threat to our very freedoms and way
of life. These sorts of concerns have made standards a new concern
for antitrust policy. Yet the fundamental premises of these theories
have received little in the way of critical examination, and empirical
verification of these theories is sorely lacking. In this paper
we will put forward a model that illustrates how standards and
products are established in the market. With this model we can
illustrate the rather stringent conditions that are necessary
in order for an inappropriate technology to become established
as a standard. Our model shows that it is highly unlikely that
antitrust policy could be used to improve upon even an imperfect
result.

We begin, however, by discussing
several aspects of this literature that have received considerable
attention but which we believe are not well understood. Sections
II through IV summarize arguments that we have presented elsewhere
which address some of the fundamental claims of this literature.

II. NETWORK EXTERNALITIES

In making a choice between the Windows
and Macintosh operating systems, most of us gave some thought
as to what the people around us were choosing or were likely to
choose. In deciding whether to switch to Windows 95 or stay with
current operating systems, many of us consider what various software
companies will do with their products that may provide a motivation
to switch to the newer operating system. The software companies'
decisions, in turn, depend on their expectations about the number
of users who will switch to the newer operating system. Many choices
are like this, with one consumer's choice depending on how other
consumers are expected to behave. The term "network externality"
has been used to denote these network elements. We prefer the
term network effect, however, reserving network externality
to apply only to those situations in which market failure causes
inefficient exploitation of a network effect. This distinction
is important because, while network effects may be found in abundance
throughout the economy, network externalities--and the policy
implications stemming from the attendant market failures--may
be rare or nonexistent.

Michael Katz and Carl Shapiro's
1985 paper on network externality in the American Economic
Review defines their subject matter as follows: "There
are many products for which the utility that a user derives from
consumption of the good increases with the number of other agents
consuming the good." They add, "[T]he utility that a
given user derives from the good depends upon the number of other
users who are in the same 'network'...." This idea of a network
embraces not only the physically connected examples of computer
networks and telecommunications systems but also, according to
Katz and Shapiro, goods such as computer software, automobile
repair, and video games. It is easy to come up with many more
examples of goods that exhibit these so called "positive
consumption externalities." When gourmet cooks more easily
find preferred ingredients because more people are taking up their
avocation, this would be a gourmet-network externality. When fans
of live entertainment prefer big cities because the large market
for entertainment assures a full variety of acts, this would be
an audience-network externality. There is virtually no limit to
these examples.

Although positive network effects
have been the main focus in this literature, there is no reason
that a network externality should necessarily be limited to positive
effects. If, for example, a telephone or computer network becomes
overloaded, the effect on an individual subscriber will be negative.
When we admit the possibility of a negative network externality,
the set of goods that exhibit network externalities expands strikingly.
As members of a network of highway users, we suffer from a negative
network externality because freeways are subject to crowding.
And although a larger installed base of computer users might lower
the price of computer software, there are many goods, such as
housing and filet mignon, where larger networks of users appear
to increase the price of the good.

The problem with all of this is
that it leads to the conclusion that almost every good exhibits
network externalities, which in turn suggests that the concept
has not been well specified. In our paper on this subject, we
demonstrate that many of the kinds of things that have been called
network externalities actually fall into a category that economists
have called "pecuniary externalities." The important
thing about pecuniary externalities is that while they are an
effect that one person has on another, they do not involve any
inefficiency. It is important to distinguish, therefore, between
network externalities that involve some direct interaction among
the network participants, and those that are mediated through
the market.

Among the remaining class of network
externalities, those that are "real" or nonpecuniary,
the interaction occurs through increasing returns in production
of some network related good, or some direct interaction among
consumers. For either case, a standard result is that as any network
gets larger, it becomes increasingly advantaged relative to any
smaller competitor networks that might exist. This leads, ineluctably,
to a conclusion that only one network can survive in any market.
This is equivalent to the phenomenon that economists have long
called "natural monopoly". The problem here becomes
the competition among the potential natural monopolists, a special
case in the economics of increasing returns, which we take up
now.

III. INCREASING RETURNS AND
PATH DEPENDENCE

Path dependence has been offered
as an alternative analytical perspective for economics. This theory
takes increasing returns--economic jargon for the condition that
bigger is better-- as its starting point, and argues that markets
and economies often get stuck with inferior products and standards.
Traditional economic analysis, it is claimed, largely ignores
increasing returns, but the "new" "positive feedback
economics" embraces the possibility. The claim that is made
for path dependence is that a minor or fleeting advantage or a
seemingly inconsequential lead for some technology, product, or
standard can have important and irreversible influences on the
ultimate market allocation of resources, even in a world characterized
by voluntary decisions and individually maximizing behavior. In
short, we get started, perhaps for no good reason, down some path
and we are unable to change to an alternative.

In our research, we define three
distinct forms of the path dependence claim. The normative implications
of these three forms differ sharply, but unfortunately the literature
has previously treated all forms of path dependence as interchangeable.
Two of these forms -- defined as first- and second-degree path
dependence -- are commonplace. They do not materially differ from
the "old" economics that they are said to replace, and
they have no normative implications. Only the strongest form of
path dependence, which we call third-degree path dependence, significantly
challenges the old economics, claiming that not only that market
solutions are flawed, but also that there are identifiable and
feasible improvements. However, the theoretical arguments for
the occurrence of this form of path dependence require important
restrictions on prices, institutions, or foresight. And this third
form of path dependence is yet to have any empirical verification.

First-degree path dependence is
simple durability without error. Initial actions, perhaps insignificant
ones, do put us on a path that cannot be left without some cost,
but that path happens to be optimal (although not necessarily
uniquely optimal). For example, a capricious decision to part
one's hair on the left may lead to a lifetime of left-side parting,
but the initial urge to part on the left might capture all there
is to be taken into account. More seriously, a decision to use
a particular electric system for powering the machinery in a plant
may be a controlling influence for decades, but the long-term
effects of the decision may be fully appreciated by the initial
decisionmaker and fully taken into account.

Second-degree path dependence is
durability in the presence of imperfect information. Information
is never perfect. It is likely therefore that decisions will not
always appear to be efficient in retrospect. If we claim that
we committed to a good choice in light of available information,
but that some other path now looks to be preferable, we are making
a second-degree claim of path dependence. In such a case, initial
conditions lead to outcomes that are regrettable and costly to
change. But, if the current costs of changing are less than the
benefits, the change is not made. Such a situation is not inefficient
in any meaningful sense, however, given the assumed limitations
on knowledge when the decision was first made.

Third-degree path dependence involves
error. It occurs where there exists, or existed, some feasible
arrangement for recognizing and achieving an outcome that is preferred
to the one chosen, but that preferred outcome is not obtained.
In this case a bad outcome is remediable, but not remedied. The
occurrence of an error that is remediable but not remedied has
significant normative policy implications. Such an error would
constitute economic inefficiency.

The three types of path dependence
make progressively stronger claims. First-degree path dependence
is a simple assertion of an intertemporal relationship, with no
implied claim of inefficiency. Second-degree path dependence stipulates
that intertemporal effects propagate error. Third-degree path
dependence requires not only that the intertemporal effects propagate
error, but that the error was, or now is, avoidable.

The failure to distinguish among
these three discrete forms of path dependence has led to some
unfortunate mistakes. The error here involves transferring the
plausibility of the empirical and logical support for the two
weaker forms of path dependence (first- and second-degree) to
the strongest implications of third-degree path dependence. Although
it is fairly easy to identify allocations, technologies, or institutions
that are path-dependent in some form, it is very difficult to
establish the theoretical case or empirical grounding for path-dependent
inefficiency.

The importance of path dependence
would appear to reside in the third-degree form. The overwhelming
share of first- and second-degree dependencies will be garden
variety durabilities that have long been well-incorporated into
economics. But if third-degree path dependence offers a "new
economics," the question arises: Does such a phenomenon exist,
and if so, what conditions bring it about?

Brian Arthur and others have suggested
that the phenomenon does exist. Their work is based on a rather
simple story that can be summarized briefly. If there is a value
in being compatible with others, then when consumers choose a
standard, such as videorecorder format, if they forecast compatibility
on the basis of the number of people already committed to each
standard, they will tend to choose only the one that is best established,
even if that standard is inferior to less well established alternatives.
In our critical writing on this, we have shown that this model,
or story, relies on extraordinary restrictions that are not likely
to be satisfied for real-world choices. In the following, we present
a richer story to consider the possibility of getting stuck with
the wrong technology.

IV. STANDARDS CONTESTS AS
A METAPHOR FOR TECHNOLOGY CHOICES

Rivalries between competing technologies
can be thought of as rivalries between standards. Standards are
the conventions or commonalities that allow us to interact. Recent
examples of battles over standards are numerous: video recording
formats, audio taping, audio compact discs, video disks, computer
operating systems, spreadsheets, word processors, telecommunications
protocols, and HDTV. Standards, networks, and technologies are
similar in that the benefits to an adopter of any of these may
depend upon the number of adopters. For example, the benefits
of a technology may depend on widespread availability of expertise,
a body of problem solving experience, and compatibility. Similarly,
it is inherent in the nature of a standard that the benefits that
accrue to an adopter will depend on the number of other adopters.

The application of path dependence
and network externality theories has offered a pessimistic prognosis
for firms that would attempt to displace an incumbent standard.
It suggests great difficulty, for example, in replacing one generation
of software with another. This would seem to promise great rewards
for the firm that did manage to control a standard, suggesting
that an entrenched standard might fall behind the capabilities
of the best available technology without inviting a viable threat
from a rival. This was the kind of concern that was raised in
the Microsoft case.

There are, however, important shortcomings
with this "entrenched incumbents" view. First, it leaves
us without an explanation of the successful replacement of one
technology with another. How did VHS displace Beta, or graphical
user interfaces displace character-based commands, or compact
discs replace records, or automobiles replace horses and carriages?
Obviously, displacement is quite common. Second, the empirical
support for such entrenchment is notably lacking. The continued
use of the ever popular QWERTY versus Dvorak keyboard story, or
Beta versus VHS story are sad commentaries on the lack of respect
for historical accuracy that has affected this literature, as
we discuss infra.

The following model has implications
that contradict the entrenched incumbents view. It does so by
incorporating different characterizations of the production and
purchase of goods that embody standards. It allows separate consideration
of the coordination advantage of standards (called synchronization
effects) and the production technology of these goods. Further,
it allows consideration of differences in tastes among consumers.
With these departures in modeling come some important results,
including these:

The expected effect of a "standards
externality" is on the amount of the standard-using activity,
not on choice of standard or the mix of standards.

Where there are differences in
preferences regarding alternative standards, coexistence of standards
is a likely outcome. Further, a single-standard equilibrium, if
it is achieved, is more readily displaced by an alternative if
preferences differ. This suggests that product strategies leading
to strong allegiances of some group of customers are likely to
be effective in the face of an incumbent standard.

Entrenched incumbents are less
entrenched when consumers react to new sales, and not just the
accumulated stocks of goods that embody standards. In particular,
a challenging standard that achieves a significant flow of adoptions
is shown to be viable. This contrasts with previous models in
which a significant installed base gives the incumbent standard
an insurmountable advantage.

A. A Model Of Standards Rivalry

The model is based on a fundamental
purpose of standards: Standards facilitate interaction among individuals.
The term "synchronization" is used to refer to this
effect. Synchronization is the benefit received by users of a
standard when they interact with other individuals using the same
standard. In general, synchronization effects will increase with
the number of people using the same standard, although it will
often be the case that users' benefits will be less closely tied
to the total number of other users of a standard and more closely
tied to the number of users with whom they actually interact.

These synchronization benefits are
distinguished from the ordinary scale effects on production costs.
Synchronization effects in our model may coexist with increasing,
decreasing or constant returns to scale. We will demonstrate that
neither scale economies in production nor synchronization effects
are by themselves necessary or sufficient conditions for an outcome
where only one standard survives.

Although it is almost taken for
granted among many commentators that average production costs
fall with increases in output for most high technology, standardized
goods, we are not so sure that this is correct. There are, we
would agree, many examples where standardization is associated,
rightly or wrongly, with lower prices. The past two decades have
witnessed decreases in the costs of computing power, telecommunications,
and video-recording, accompanied by increases in the use of computer
software, new methods of communications, and video recorders.
Consequently, theories that invoke economies of scale have had
an easy time capturing our attention.

But there is no reason to believe
that the goods referred to as "high-tech" are necessarily
subject to increasing returns to scale. The technical advances
associated with new technologies may easily disguise actual diseconomies
of scale in production. This is the difference between a movement
of an entire cost schedule or curve, and a movement along a single
schedule, a point made in almost all elementary economic texts,
and one that is well understood by economists.

Being able to distinguish between
these possibilities on an empirical level, however, is
another matter. Some of the most eminent economists, such as Alfred
Marshall, have confused a shift in an average cost curves over
time with movements down a single average cost curve. Advances
in technology are likely to lead to increases in output and lower
prices, but this should not be confused with economies of scale
in production.

These new high-technology goods
are also likely to be associated with unsettled format choices.
The eventual adoption of a standard, which may take several years
or even decades, often occurs simultaneously with improvements
in technology, making an examination of correlations between time
series of standardization efforts and production costs misleading.
Certainly, an empirical association exists between the adoption
of standards and decreases in costs: IBM's personal computer became
the dominant format, and computer and software prices fell while
the number of computers and programs rose; prices of fax machines
and modems fell dramatically after settlement on a standard compression
routine. However, the drop in costs associated with the standardization
of many new technologies can not be taken as evidence in favor
of increasing returns in the production of standardized goods,
since the new technologies often lead to rapid decreases in (quality
adjusted) costs over time, with or without standardization. For
example, although VCR prices fell after VHS won its standardization
battle with Beta, VCR prices had also fallen while both formats
possessed significant market shares.

The model that follows provides
independent consideration of the impacts of synchronization effects
and production cost economies and diseconomies. While the synchronization
effect, like the effect of any ordinary fixed cost of production,
favors the domination of an industry by a single format, it does
not guarantee such a result.

B. A Model Of Standard Selection

Consider a setting in which two
formats compete. Current consumer choices are affected by the
market share of each format during a recent time period. A consumer
commits to a format, for at least a while, by purchasing a product
with that particular format. For concreteness and familiarity,
the discussion will be presented as a choice between Beta and
VHS, in which commitment to a format occurs with the purchase
of a VCR.

For several reasons, we assume consumers
make purchase decisions on the basis of shares (percentage of
market controlled by a standard) rather than scales (total output
of a standard). First, there is the issue of synchronization costs:
if most of the world uses VHS, the fact that the number of
Beta users is increasing may be largely irrelevant. Second, for
any given scale of a good with standard activity, relative share
will determine relative scale. Finally, consumer choices will
often be for one format versus another, so that it is the relative,
not absolute, benefit of the standard that will affect consumer
decisions.

1. The Consumer

Assumptions about consumer values
that are the basic building blocks of our model are shown in figure
1. The horizontal axis shows, for the most recent time period,
the market share of one format. In our example, the horizontal
axis is the share of VHS VCRs as a percentage of all VCRs sold
during this period.

We define the autarky value of an
individual's investment in a VHS video recorder to be its value
assuming no interaction among VHS users (i.e. no other VHS users).
A VCR presumably has value even if tapes are never rented or exchanged.
But a positive autarky value is not required for the model. In
some activities, such as communication with fax machines or modems,
it is reasonable to assume an autarky value of zero.

The synchronization value is the
additional value that results from the adoption of the format
by other consumers. By assumption, the synchronization value assigned
by a potential consumer is directly correlated with increases
in the consumer's estimate of that format's future market share.
Further, we hold that consumers use the format's current market
share to estimate the future share of the stock. Thus, the synchronization
value of VHS increases with its share of the market.

Total value, defined as the autarky
value plus the synchronization value, will increase as the format's
market share increases.

Figure 1 shows the value of a format
to an average consumer based on its share of the current period's
sales (flow).

2. Production

For many standards, an individual's
adoption of the standard occurs with the purchase of a single
standard-embodying good, such as a computer, a camera, a typewriter,
or a videocassette recorder. For these standards, the conditions
of production will influence outcomes in social choices regarding
standards.

Production of VCRs could be subject
to increasing, decreasing or constant cost. For now, we will assume
price-taking behavior by producers. For a given total quantity
of VCRs sold, the flow of a particular format will, of course,
increase directly with the share. Figure 2 shows the supply price
function under the assumption that VCR production involves increasing
cost. (Other specifications of cost are allowed and discussed
below. Here, the figure illustrates a single possible configuration.)

From these relationships, a net
value function for videorecorder formats can be derived. The net
value function is equal to the total value (the autarky value
plus the synchronization value) less supply price. Since the total
value increases more rapidly than supply price in figure 2, the
net value increases as VHS's share of the market grows.

The net value functions for machines
with the Beta format can be constructed in the same fashion. Net
value functions will be upward-sloping if the supply price function
is less steeply upward-sloping than the synchronization value
function. In other words, if decreasing returns in production
overwhelm synchronization benefits, the net value line falls with
market share. On the other hand, if synchronization benefits are
greater than decreasing returns in production, or if production
exhibits increasing returns, then the net value curve is upward
sloping, as in figure 3.

As we shall see, it is only when
the net value function is upward-sloping that choices between
standards are fundamentally different in character from choices
of other goods (i.e. exhibit increasing returns instead of decreasing
returns). We assume throughout the analysis that the slope of
the net value function for a given format has the same sign for
all consumers.

The net value functions for Beta
and VHS are put in a single diagram in figure 3. As VHS share
varies from 0% to 100%, Beta share varies from 100% to 0%. If
the two formats have identical costs and benefits, the Beta net
value curve will be the mirror image of the VHS net value curve.

The intersection of the two curves
(if they intersect), labeled Di, represents the market share equilibrium
where the consumer is indifferent between the two formats. This
value plays a crucial role in our analysis. On either side of
Di, the consumer will have a preference depending on the slopes
of these curves. For example, if each net value curve is upward-sloping
with respect to its own market share, as in figure 3, the consumer
will prefer VHS when its market share increases beyond Di (VHS
has higher value, relative to Beta, as the VHS share increases
beyond Di). If the two net value curves are downward sloping with
respect to their own market shares, however, the consumer will
prefer Beta as VHS share increases beyond Di.

Note that this analysis assumes
that the consumer does not take into account the impact of his
decisions on other consumers (i.e. he does not consider how his
purchase of a video recorder will alter the valuation to other
potential purchasers of video recorders). Therefore, the door
is still left open for some sort of (network) externality.

3. The Market

Each customer has an individual
Di, a equilibrium point at which the two formats are equally valuable.
Accordingly, a population of customers will have a distribution
of Di's. Let G(xj) be the fraction of VCR purchasers with Di<xj,
that is, G(x) is the cumulative distribution function for Di.
This distribution is a key to the selection of a standard.

Perhaps the most basic distribution
would be one in which all consumers had the same tastes, so that
Di is the same for all consumers. Call this common value Di*.
This resulting cumulative distribution is shown in figure 4. The
cumulative function is actually the share of the population that
will buy VHS next period based on different current market shares
of VHS.

Returning to figure 4, we can now
see that the candidates for equilibrium are A, B, and C. Points
A and C are single format equilibria which are stable: For flows
near 0% VHS, all consumers will choose Beta, for flows near 100%
VHS all consumers will choose VHS. In contrast, B is an unstable
equilibrium. At flows near but to the left of Di* all consumers
would choose Beta, at flows near but to the right of Di*, all
consumers choose VHS. So, for the case of upward-sloping net value
curves, we obtain an either/or choice that is often argued to
be the expected outcome for standards. An upward-sloping net value
curve, however, is nothing more than the traditional "natural
monopoly."

Consider the outcome for downward-sloping
net value curves. In this case, all consumers with Di less than
the prevailing flow choose Beta. The function G(x) thus reveals
the fraction choosing Beta. The function 1-G(x), which is the
fraction choosing VHS, is shown in figure 5. The only possible
equilibrium is B, a stable equilibrium. At points near, but to
the left of Di*, VHS machines are more advantageous than Beta
machines (through effects on supply price) and more consumers
would choose VHS. Similarly, displacements of equilibrium to the
right of Di* would increase the relative advantage of Beta machines,
moving the outcome back to the left.

Consumers split their purchases
so that a VHS purchase and a Beta purchase have identical net
value. This describes a circumstance in which the formats will
coexist. This result is significant because it demonstrates that
even without differences in taste (which favors coexistence),
it is still possible for a mixed-format equilibrium to exist.

The mere existence of synchronization
effects can now be seen as insufficient to establish the either-or
choice with respect to standards. That is because synchronization
effects cannot, by themselves, ensure upward-sloping net value
curves.

This model of standardization provides
some interesting insights. The nature of the equilibrium, either
as a mixed format or as an either-or equilibrium, depends on the
slopes of the net value curves, and synchronization effects are
only part of the story. For example, upward-sloping net value
curves can occur when supply price falls, even when there is no
synchronization effect. The existence of synchronization effects,
the raison d'être of standardization, also does not
rule out the possibility of downward sloping net value curves,
and the resulting efficient coexistence of formats. Synchronization
effects, therefore, are neither necessary nor sufficient conditions
for an either-or equilibrium.

In fact, it is possible that the
either-or equilibrium is mostly driven by production costs and
not network effects. For example, if software categories were
to be dominated by single entries, it would likely be due to the
large fixed cost element in the production of software
titles as opposed to synchronization effects. But arguments that
network effects might lead to software monopolies (as claimed
of Microsoft) miss the point. Software creation may be just a
newer version of a natural monopoly in terms of old fashioned,
prosaic production costs, which are quite independent of any network
effects. Large fixed costs leading to (natural) monopoly can just
as well be used to characterize the publishing or movie business.

Yet what would be the implications
for antitrust? If the market is a natural monopoly, whether due
to synchronization or production costs, there would be no benefit
in trying to force the market into a competitive structure with
many overly small firms having excessively high production cost
structures and low synchronization values for consumers. The government
might wish to award natural monopoly franchises, as it does for
most public utilities, but the history of publicly regulated utilities
does not inspire confidence that technological advancement would
be promoted, or that costs would be kept down. Since high technology
changes so frequently, a firm that achieved monopoly with one
technology will not be able to hold on to its lead unless it is
extremely resourceful. This further argues against the value of
government intervention in technology markets.

4. Internalizing Synchronization
Costs

Thus far, the model addresses only
private valuations and their effects on outcomes. Since the literature
has been preoccupied with how one consumer's format choice affects
the values enjoyed by others, we should also examine how internalizing
this externality would affect standard choice. We must note, however,
that a single owner of a technology or standard is capable of
internalizing the impact of consumer's behavior through prices.
The following discussion therefore applies to the case in which
a technology is not owned by a single entity.

To this point the net value curves
have represented private net benefits. Since the synchronization
effect is always assumed to have a positive effect on other users
of the same format, the social net value function, which includes
the synchronization value to others, will always lie above the
private net value function, regardless of the slope of the private
net value function. The difference in height depends on the relative
strength of the synchronization effects and the format's market
shares. For example, at zero share of VHS, the VHS private net
value curve will be the same as the VHS social net value curve.
That is because, where there is no user of VHS to benefit from
this individual's purchase, the private and social values must
coincide. Where VHS has a positive market share, the social net
value curve is everywhere above the private net value curve. This
case is shown in figure 6. As the share of VHS increases, and
the number of potential beneficiaries of this individual's VHS
purchase increases, the difference between the social and private
net value curves increases. The same would be true for Beta net
value curves.

Depending on the relative sizes
of the synchronization effects on users of the two formats the
intersection of social net value curves can be to the right or
left of the intersections of the private net value curves. In
the particular case where the two formats attract users with the
same levels of potential interaction and where the private net
value curves are the same, internalizing the synchronization externality
will have no effect on any individual's Di, and thus no effects
on the potential equilibria.

If, in the more likely case where
the Di's move to the left or right, the cumulative distribution
function would also move in the same direction. In that case,
internalizing the synchronization externality may lead to a different
equilibrium.

But even if the Di* in figure 4
moves left or right somewhat, when the market starts near point
A, that will remain the equilibrium, and if it starts near point
B, that will remain the equilibrium. Thus even if internalization
of the externality changes Di's, the final market equilibrium
need not change. Internalizing the synchronization effect thus
might have no impact on the choice of format.

There is one dimension where the
internalization of the synchronization effect always has an impact,
however. The private net value functions consistently undervalue
videorecorders. Therefore, it is not the relative market
shares, but rather, the size of the overall market that will be
affected by this difference between private and social net value
functions. Too few videorecorders of either type will be produced
if the synchronization effect is not internalized by the market
participants. Internalizing the externality enhances both
VHS and Beta, causing consumption of VCR's to increase even if
market shares remain constant. This is completely compatible
with the conventional literature on ordinary externalities. All
this is really saying is that too little of a product will be
produced if there is a positive externality (e.g. too few golf
courses, or too few copies of Microsoft Excel) and too much will
be produced if there is a negative externality (e.g. pollution).
This is a far more likely consequence of "network externalities"
than the more exotic case of winding up with the wrong standard.

C. Extending The Model

There are several natural extensions
of this model. The assumption that all consumers have the same
Di can easily be relaxed. Allowing consumers to differ in their
Di's acknowledges differences in tastes. These differences may
reflect different assessments of the formats, different synchronization
values, or both.

Assume that the Di's for consumers
range between 20% and 80% (VHS), and that within this range the
distribution of Di's are uniform, as illustrated in figure 7.
The height of the distribution of Di's indicates the slope of
the cumulative distribution function. The cumulative distribution
function, therefore, has a straight line segment between (20,0)
and (80,100) as shown in figure 8, and intersects the 45 degree
diagonal at points A, B, and C. If the net value functions are
upward-sloping with respect to own market share, A and C would
be stable equilibria and B would not. Thus, this type of uniform
distribution of Di's gives the same general result as the assumption
that all consumers have identical Di's. Thus, under these assumptions,
we tend to get an either/or equilibrium.

If the net value function were falling
with respect to own market share, the corresponding figure would
be the vertical mirror image of figure 8. Point B would be the
only stable equilibrium in flows. Consumers would buy the format
that they most valued, unless it suffered a cost disadvantage
due to its popularity. With decreasing returns, we expect many
formats (brands, producers) in the market. Because this result
is so standard, we focus our attention on the less standard case
where net value rises with market share, i.e. where natural monopoly
in production is a possible outcome.

1. Strong Differences In Tastes

Up to this point, the results of
the model indicate that when net value curves are upward-sloping,
the equilibrium will be of the either/or type. This need not be
the case. Figure 9 shows a distribution of Di's representing the
very reasonable case where each format has a fairly large number
of adherents, with the rest of the population of Di's thinly (and
uniformly) distributed between 20% and 80% VHS.

The distribution of Di's in figure
9 results in the cumulative distribution function shown in figure
10. The only stable equilibrium in this case is point B. The differences
in tastes allow two standards to coexist in a stable equilibrium,
even where net value curves are upward-sloping. This is an important
result. In those instances in which each format offers some advantages
to different groups of customers, we should expect to find that
different formats appeal to different people. When this is so,
formats can coexist in a market equilibrium, and individual consumers
are not deprived of one of the choices.

It is important to point out that
this is the likely path that markets are expected to follow when
there are strong natural monopoly elements. Although a Hotelling
model might predict that two firms will produce nearly identical
products, we would expect (entrant) firms to try to specialize
their products to appeal to particular groups of users. This is,
after all, one simple way for firms to overcome any natural monopoly
advantage that might exist in production costs of an incumbent.
The incumbent firm, on the other hand, might do well creating
products that appeal to the widest possible audience in an attempt
to foreclose this possibility.

There are some straightforward implications
here. First, even when there are economies of scale and/or network
effects, the market can allow more than one format to survive.
The key to success is to find a market niche and to produce a
product that is as close to the preferences of that market segment
as possible. Unless the established firms are much larger and
have much lower costs, the superior characteristics for the entrant's
product, as viewed by the consumer niche, will provide sufficient
advantage for the entrant to survive. If each producer can produce
a product that appeals to a segment of the population, then the
situation represented by figure 10 will occur. That this result
is so grounded in common sense does not, to us, diminish its value.

2. Results When One Product Is Superior
To Another

It is more complicated to define
a superior standard than might be thought. In the rather lopsided
case of one format having higher net values than another by all
consumers in all market shares, that format clearly would be superior.
It is also not difficult to see that in this case, no Di would
occur in the interior of 0-100%, and that the only equilibrium
is at a share of 100% for the superior format. But it is not common
to find such lopsided circumstances. Strongly held, but divergent,
preferences lead to different results. If some individuals prefer
format A, regardless of share, and others prefer format B, regardless
of share, then it is not clear that either can be said to be superior.

For our purposes, however, we shall
define standard A to be superior if, for all consumers and any
market share X, the net value of A is higher than the net value
of B with the same market share (e.g. if all consumers prefer
A with 100% share to B with 100% share; similarly, all prefer
A when both A and B share 50% of the market).

Assume that VHS is the superior
standard. The Di's will then all be less than 50% since individuals
would only choose Beta when it had the dominant market share.
Assume that the Di's are uniformly distributed between 0% and
20%. Then the cumulative density function lies above the 45 degree
line everywhere, as shown in figure 11. Figure 11 is the same
as figure 8 except that the upward-sloping segment is displaced
to the left. A and C are the only two equilibrium points, but
only C is a stable equilibrium. This analysis implies that
if society starts at 100% Beta, it could get stuck at A, but only
if no one ever purchases a single VHS machine.The trap
at A, being an unstable equilibrium, is incredibly fragile.

In this case it is almost certain
that the superior format dominates the market. If VHS is superior
and both formats originate at the same time, VHS will win unless
Beta, although inferior, can somehow capture and keep a
market share of 100%. This would seem an almost impossible task
for the Beta producers. It is unlikely, however, that both formats
would come to market at the same time. If VHS arrives first, Beta
need not bother showing up. If Beta arrives first, as it in reality
did, then it has a market share of 100% prior to the arrival of
VHS. If the entrenched stock is large and if it also has an influence
on expected future market shares, then the distribution of Di's
would be shifted to the right. This implies the possibility of
an equilibrium that is different from C. This is the instance
of being 'stuck' in an inferior format.

D. An Example Of Getting
Stuck

It is not difficult to alter the
previous example so that C becomes a stable equilibrium, even
though VHS is preferred by all consumers. One simple alteration
is merely to assume some minor changes from those conditions represented
in figure 11. For example, as noted above, Beta might have an
advantage in the existing stock and consumers might take into
account the established base of previous sales in addition to
sales this period. Under that assumption we let the Di's range
between 10% and 30%, instead of the former 0% and 20%. The market
now can be represented by figure 12. Because all consumers prefer
Beta when the share of Beta is greater than 90%, the cumulative
distribution function is no longer always above the diagonal,
and point A becomes a stable equilibrium in addition to point
C. Point B, at 12.5% VHS, now is an unstable equilibrium.

Notice that the possibility of getting
stuck does not require the existence of any synchronization (network)
effect. Upward-sloping net value curves are all that are necessary,
and this can be achieved merely with old-fashioned scale economies
in production.

E. Getting Unstuck

Under the conditions discussed above,
where the market settles at A, owners of the VHS format have an
incentive to alter conditions to attempt to dislodge the market
from A. One method might be to dump a large number of VHS machines
on the market, perhaps by lowering the price, in order to generate
an immediate 12.6% market share, driving the equilibrium to C.

Producers of VHS can also try to
prime the pump on sales by providing deals to the largest users,
or distributors, or retailers (perhaps offering side payments)
to convince them to switch to VHS. If this action can provide
a market share of 12.5%, VHS can dislodge Beta [as of course it
did]. Of course, if the VHS format were not owned, there would
have been a potential free rider problem for the VHS producers
to solve before these strategies could have been adopted.

There are other alternatives as
well, including advertising, publicity, and services to allow
partial or total compatibility. [VHS, with RCA's expertise, did
put on a large publicity blitz in the US]. Interestingly, VHS,
through a combination of lower prices, clever advertising, and
most of all, a product considered superior by most consumers,
overtook Beta within six months of introduction in the US.

It is important to note that the
larger the difference between the two formats, the easier it is
for the superior format to overcome any initial lead of an inferior
standard. For truly large differentials, we should expect diagrams
like figure 11, not figure 12. Thus, the greater the potential
error in the choice of a standard, the less likely it is that
an error would be made.

Additionally, the greater the difference
in the format, the greater the difference in potential profits
between formats and the more likely the superior format can get
financing to engage in the pump-priming type of activities that
we alluded to above. In a circumstance like the ones presented
above, all other things equal, the technology that creates more
wealth will have an advantage over a technology that creates less.
While the owner of a technology may not be able to appropriate
its value perfectly, owners of a superior format can be less perfect
at overcoming their appropriation problems and still win the competition.

The role of antitrust should be,
basically, to get out of the way here. The various pump-priming
measures discussed above may well look predatory, but the superior
format must be allowed to engage in actions that can help ensure
it survives and prospers, particularly if it is not the first
format offered to users. If the superior technology is offered
first, we are unlikely to see a sustained attempt to dislodge
the leader by the owners of inferior technologies, unless they
expect that they can achieve their ends through political means,
since their expenditures in the market are likely to be futile.
If government is to do anything useful, it should help to ensure
that the capital market is functioning properly so that new technologies
have access to sufficient financing. The recent episode with Netscape
and its enormous market capitalization seems to indicate that
such financing is more than abundant.

It may not always be apparent how
or if a technology is owned. Ownership of a technology can take
various forms including ownership of critical inputs, patent,
copyright, and industrial design. Literal networks such as telephones,
pipelines, and computer systems are most often owed by private
parties. Sony licensed the Beta system, JVC-Matsushita the VHS
system. Standards are often protected by patent or copyright.
Resolution of these startup problems may be an important and as
yet not fully recognized function of the patent system and other
legal institutions.

F. Other Methods For Getting
Unstuck

Transactions are one method for
avoiding an inefficient standard or moving from one standard to
another. In some circumstances, the numbers of people who interact
through a standard is small enough that transactions are a feasible
method of resolving any externalities regarding the standard.
A small group of engineers working together can certainly get
together and decide to use a different CAD package. Or an extended
family can coordinate the choice of Camcorder format so that tapes
of grandchildren can be exchanged.

Another tactic for dislodging an
inferior standard is convertibility. Suppliers of new-generation
computers occasionally offer a service to convert files to new
formats. Cable-television companies have offered hardware and
services to adapt old televisions to new antenna systems for an
interim period. For a time before and after the Second World War
typewriter manufacturers offered to convert QWERTY typewriters
to Dvorak for a very small fee.

All of these tactics tend to unravel
the apparent trap of an inefficient standard. But there are additional
conditions that can contribute to the ascendancy of the efficient
standard. An important one is the growth of the activity that
uses the standard. If a market is growing rapidly the number of
users who have made commitments to any standard is small relative
to the number of future users. Sales of audiocassette players
were barely hindered by their incompatibility with the reel-to-reel
or eight-track players that preceded them. Sales of sixteen-bit
computers were scarcely hampered by their incompatibility with
the disks or operating systems of eight-bit computers.

We thus conclude that instances
of getting stuck with the wrong standards, when the standards
are chosen in the market, should be few and far between. In the
next section, we present a summary of our prior work that critically
examines two popular case studies used to support the notion of
an inferior standard "trap." We conclude by applying
the lessons of this work to the recent computer operating system
debate.

V. EMPIRICAL EXAMPLES OF
STANDARD CHOICE

A. The Fable Of The Keys

Paul David introduced economists
to the conventional story of the development and persistence of
the current standard keyboard, known as the Universal, or QWERTY,
keyboard. Paul Krugman, in his recent book "Peddling Prosperity,"
speaks approvingly of this entire literature in a chapter entitled
"The Economics of QWERTY." The significance of the keyboard
example to this literature can not be overstated.

QWERTY refers to the letters in
the upper left hand portion of the typewriter (and computer) keyboard.
One commonly hears the claim that to keep the old-fashioned mechanisms
from jamming on the early typewriters the mechanics who created
the keyboard actually designed the keyboard to slow down typing
speed. The claim is made that QWERTY's ascendance was due to a
serendipitous association with the world's first touch-typist,
who won a famous typing contest using the QWERTY design. The QWERTY
design is reputed to be far inferior to the "scientifically"
designed Dvorak keyboard which claimed to offer a 40% increase
in typing speed. Supposedly, the Navy conducted experiments during
the Second World War demonstrating that the costs of retraining
typists on the new keyboard could be fully recovered within ten
days of their retraining! According to path dependency theory,
no producers found it profitable to create Dvorak keyboards since
everyone already knew QWERTY, and no one learned Dvorak because
there were no Dvorak keyboards.

This is an ideal example, which
accounts for its continued use by virtually every author looking
for an example of path dependence. The number of dimensions of
performance are few and in these dimensions the Dvorak keyboard
appears overwhelmingly superior. This example is so good that
one might think that it would have had to have been invented if
it didn't already exist. Although the story was not invented by
economists, there is a great deal of invention in the story as
told. Certainly, this story has not been held to rigorous standards
of scientific skepticism, since the story is false in almost every
detail.

The QWERTY keyboard, it turns out,
is about as good a design as the Dvorak keyboard, and was better
than most competing designs that existed in the late 1800s when
there were many keyboard designs maneuvering for a place in the
market.

Ignored in these stories of Dvorak's
superiority is a carefully controlled experiment conducted under
the auspices of the General Service Administration in the 1950s
comparing QWERTY with Dvorak. In the experiment, a group of typists
were retrained on the Dvorak keyboard. When these retrained Dvorak
typists regained their prior QWERTY speed, a group of QWERTY typists
began additional training on the QWERTY keyboard, while the new
Dvorak typists continued their training. This parallel training
is important because it is always possible to improve a typist's
performance on any keyboard with additional training. The QWERTY
typists were carefully selected to constitute a proper control
group for the Dvorak typists, and other scientific controls were
applied. The conclusion of the study was that the QWERTY typists
always performed better than the Dvorak typists. Thus the experiment
contradicted the claims made by advocates of Dvorak and concluded
that it made no sense to retrain typists on the Dvorak keyboard.
This study, which was influential in its time, brought to an end
any serious efforts to shift from QWERTY to Dvorak.

Modern research in ergonomics also
reaches similar conclusions. This research consists of simulations
and experiments that compare various keyboard designs. It finds
little advantage in the Dvorak keyboard layout, confirming the
results of the GSA study.

So on what basis were the claims
of Dvorak's superiority made? We discovered that most, if not
all, of the claims of Dvorak's superiority can be traced to the
patent owner, Professor August Dvorak. Yet his book on the relative
merits of QWERTY versus his own keyboard has about as much objectivity
as a modern infomercial found on late night television.

The wartime Navy study turns out
to have been conducted under the auspices the Navy's chief expert
in time-motion studies, Lt. Commander August Dvorak, and the results
of that study were clearly fudged. The study compared the performance
of two groups of typists, one that trained in Dvorak and another
that trained in QWERTY. The two groups were not comparable and
the data on the two groups were not treated in the same way. For
example, the typing speed for the Dvorak group was measured on
the first and last days of training, while the data for the QWERTY
group was measured as the averages of the first four days and
the last four days. This clearly truncated the effective training
time for the Dvorak group. The study also appears to be lacking
in anything remotely related to objectivity. The difficulties
that we had getting a copy of the Navy study, and the fact that
it is mentioned, but never actually cited, convinced us that those
economists enamored of the Dvorak fable never actually perused
a copy of that study.

Many other aspects of the received
story were also erroneous. It turns out that there was intense
competition between producers of various keyboard designs early
in the history of the typewriter keyboard. And contrary to prior
claims, there were many typing competitions between touch typists
on various keyboard designs, and QWERTY won its share of such
competitions. QWERTY was put through a fairly severe set of tests
by the market, and the reason QWERTY survives seems to be that
it is a reasonably good design. Thus it is not by incredible luck
that we ended up with a reasonable standard. Rather, our good
fortune in inheriting a reasonably efficient standard may be attributed
to QWERTY's success in these severe tests.

We published a very detailed account
of this in the Journal of Law and Economics in the spring
of 1990. Yet in spite of this six-year-old paper, which has not
been factually disputed, economists working on path dependence
topics continue to use the QWERTY keyboard as the main example
to support their theory that markets cannot be trusted to choose
products. One could hardly find better evidence of this theory's
lack of empirical support than the continued use of a result that
is known to be incorrect.

B. A Tale Of The Tape: Beta
Vs. VHS

After the typewriter story, the second
most popular illustration of harmful lock-in is the contest between
the Beta and VHS videotaping format. It is often claimed that
Beta was a better format and that VHS only won the competition
between formats because it fortuitously got a large market share
early on in the competition with Beta. But this story turns out
to be just as inaccurate as the keyboard story.

In 1969, Sony developed a cartridge-based
videorecorder, the U-matic, which it hoped to sell to households.
Since other companies had such products in the works, Sony persuaded
Matsushita and JVC to produce the machine jointly with Sony, and
to share technology and patents. The U-matic was not a success
as a home machine, though it did find a niche in educational markets.
The U-matic was followed by many other unsuccessful attempts to
break into the home market.

In the mid 1970's, Sony developed
the Betamax. Believing that with the Betamax it finally had a
machine that would succeed in the home, Sony again offered the
machine to Matsushita and JVC. Once again, Sony hoped to establish
a standard that would cut through the clutter of competing formats.
But months after Sony had revealed much of its technology to its
erstwhile partners, JVC demonstrated a new machine (VHS) that
led Sony engineers to conclude that JVC had expropriated their
ideas. This apparent usurping by JVC of Sony's technological advances
created bitterness between the one-time allies, leaving Sony and
Matsushita-JVC to go their own separate ways.

The only real technical difference
between Beta and VHS was the manner in which the tape was threaded
and, more importantly, the size of the cassette. The choice of
cassette size was based on a different perception of consumer
desires. Sony believed that a paperback sized cassette, allowing
easy transportability (although limiting recording time to 1 hour
at the time), was paramount to the consumer, whereas Matsushita
believed that a 2 hour recording time, allowing the taping of
complete movies, was essential.

The larger VHS cassette accommodated
more tape. For any given tape speed this implied a greater recording
time. Slowing the tape increases the recording time, but also
decreases picture quality. VHS, because of its larger size cassette,
could always have an advantageous combination of picture quality
and playing time. This difference was to prove crucial.

In an attempt to increase market
share, Sony allowed its Beta machines to be sold under Zenith's
brand name, a highly unusual move for Sony. To counter this move,
Matsushita allowed RCA to puts its name on VHS machines. Although
Sony was able to recruit Toshiba and Sanyo to the Beta format,
Matsushita was able to bring Hitachi, Sharp, and Mitsubishi into
its camp. Beta slowed down the tape and increased its playing
time to two hours; VHS did the same and increased playing time
to four hours. RCA radically lowered its machines' prices and
came up with a simple but effective ad campaign which touted VHS's
advantage: "Four hours. $1000. SelectaVision." Zenith
responded by lowering the price of its Beta machine to $996.

The market's referendum on playing
time versus tape compactness was decisive and rapid. Beta had
an initial monopoly that held up for almost two years. But within
six months of VHS's introduction in the US, VHS was outselling
Beta. These results were repeated in Europe and Japan. By mid
1979 VHS was outselling Beta by more than 2-to-1 in the US. By
1983, Beta's world share was down to 12 percent. By 1984, every
VCR manufacturer except Sony had adopted VHS.

Not only did the market not get
stuck on the Beta path, it was able to make the switch to the
slightly better VHS path. Notice that this is anything but path
dependence. Even though Beta got there first, VHS was able to
overtake Beta very quickly. This, of course, is the exact opposite
of the predictions of path dependence, which implies that the
first product to reach the market is likely to win the race even
if it is inferior to later rivals. For most consumers, VHS offered
a better set of performance features. The market outcome, in which
VHS prevailed, is exactly what they wanted.

The lesson offered to us in the
path dependence literature is that markets cannot be trusted to
chose the right products. We argue that a better lesson is that
public policies and legal theories should not be based on a literature
that is itself based on only the most casual sort of empirical
analysis.

C. Computer Operating Systems
- Mac Versus IBM

It is often claimed that the Macintosh
operating system is better than either the DOS system or the DOS-based
Windows system that followed. However, these standards are not
fixed, but instead can and do evolve. The IBM operating system
evolved into one that is very similar to the Macintosh. It is
possible, in fact, that the Macintosh was introduced too early,
for its operating system was more than the hardware of the time
could handle with reasonable performance and cost.

DOS had advantages when processors
were slow and memory was scarce, since text based displays were
much more rapidly displayed and required far less memory. Printers
also were not generally up to the task of printing graphical images
of pages, except for PostScript printers which required gobs of
memory, a very expensive license to use the postscript page description
language, and a fast processor to interpret the language and convert
the textual commands into graphical images. For ordinary businesses
and ordinary users, these advantages of the Macintosh were largely
extravagances that could easily be foregone. Even Windows did
not really take off until the power of computers was able to overcome
its sluggish performance relative to DOS.

As processors, hard drives, and
memory increased in speed and power, graphical interfaces increased
in attractiveness. Printers also increased commensurately in power.
If the MS-DOS world were still using DOS, there is little doubt
that Macintosh would have dramatically increased its market share
and might now be the dominant brand. But Microsoft apparently
understood this. Windows, and now Windows95, have migrated toward
the Macintosh path (which in fact was the path originated by the
Xerox Palo Alto Research Center), so the original Macintosh backers
were correct in their view that many of the features that confronted
the user in the Macintosh system were theoretically and aesthetically
better than DOS. The fact that a particular brand did not
dominant should not be confused with the inability of a technology
to dominate. Again, individual choices led to a solution that
appears to be efficient.

VI. CONCLUSIONS

High technology goods, and computer
software in particular, pose interesting problems for economic
analysis. It may be that some types of software products should
be produced by only a single supplier. But, this is not the usual
venue for antitrust. There might be reason to intervene in the
market if there were evidence that rivalry in the marketplace
was moribund. But, the evidence seems to be overwhelmingly to
the contrary. Or, there might be reason to intervene if there
were evidence that these industries were seriously deficient in
technological progress. But, there is no such evidence. There
might be reason to overturn the market's selection of a standard
if it could be shown that markets are systematically deficient
at such choices. But, as we have shown, this is an unlikely event,
and there is as yet no evidence to support such a view.

We have presented a different view
of how markets generally function. In our model individuals have
foresight, entrepreneurs have ambition, and knowledge is a prized
asset. In the alternative world view consumers are myopic and
entrepreneurs are either timid or impotent. In this latter world
it is not surprising that accidents have considerable permanence
and that mistakes are not corrected. In such a world there are
no agents who might profit by devising some means of capturing
a part of the aggregate benefits of correction.

If we follow the advice given by
many proponents of concepts such as path dependence and network
externalities we will likely be handicapping a sector of the economy
that has been one of, if not the most, powerful source of growth,
innovation and vitality in domestic and international markets.
This government interference with high-technology markets would
not be based on well supported theories of monopoly behavior,
but rather would be based on theories that are highly speculative
and generally without any empirical support. Further, attempts
to convert these theories into an antitrust agenda as proposed
by the Reback White paper have carried these economic theories
to outlandish extremes.

The misuse of economic theory for
public policy purposes cannot be in the country's long run interest.
Even if one does not like Microsoft, its CEO, or its products,
it is still a mistake to use antitrust as an instrument with which
to bludgeon Microsoft, since there is no telling where the misuse
of antitrust will next appear. The high technology marketplace
appears to be quite capable of disciplining any firm that does
not address the needs of its consumers, as is demonstrated by
the extraordinary rate of turnover of product leaders in these
markets. Above all else, the theory that is alleged to underpin
such antitrust action is a theory that, at best, is of limited
applicability and, at worst, is simply wrong. Consumers, manufacturers,
regulators and economists will all be better off when our discourse
is based on theories that have empirical confirmation in the real
world.

FOOTNOTES

. See Gary L. Reback et al., Why Microsoft
Must Be Stopped, UPSIDE, Feb. 1995, at 52, 52-67. These authors
argue that Microsoft's ownership of operating system standards
will be leveraged into eventual domination of the entire information
mechanism of society:

It is difficult to imagine that in an open society
such as this one with multiple information sources, a single company
could seize sufficient control of information transmission so
as to constitute a threat to the underpinnings of a free society.
But such a scenario is a realistic (and perhaps probable) outcome.

Id. at 65.

. Arguments of this type were apparently important
in the federal district court's decision to reject a settlement
between Microsoft and the United States Department of Justice.
United States v. Microsoft Corp., 159 F.R.D. 318, 333-38 (D.D.C.
1995) (Sporkin, J.), rev'd, 56 F.3d 1448 (D.C. Cir. 1995).
"Microsoft is a company that has a monopolistic position
in a field that is central to this country's well being, not only
for the balance of this century, but also for the 21st Century....In
this technological age, this nation's cutting edge companies must
guard against being captured by their own technology and becoming
robotized." 159 F.R.D. at 337-338. The Justice Department's
recent examination of the Microsoft Network and Windows 95 seems
to be based on similar reasoning, particularly since it is hard
to imagine any reasonable context using standard antitrust criteria
for such an investigation at the embryonic stages of a product.
Even the roadblocks thrown up by the Justice Department during
Microsoft's proposed acquisition of Intuit (the leader in personal
finance software) seem likely to have been influenced by such
thinking.

For an illustration of the role that this idea of
path dependence has played in challenging the neoclassical economic
paradigm, see the recent exchange between Samuel Bowles &
Herbert Gintis, The Revenge of Homo Economicus: Contested Exchange
and the Revival of Political Economy, J. ECON. PERSP., Winter
1993, at 83; and Oliver E. Williamson, Contested Exchange Versus
the Governance of Contractual Relations, J. ECON. PERSP.,
Winter 1993, at 103. See also Oliver E. Williamson, Transaction
Cost Economics and Organization Theory, 2 INDUS. &AMP; CORP.
CHANGE 107, 131-32, 141 (1993) (discussing influence of institutional
characteristics and state of knowledge on scope for improving
on market outcomes).

For one instance in which efficiency claims are
evident, see Paul A. David, Heroes, Herds and Hysteresis in
Technology History: Thomas Edison and 'The Battle of the Systems'
Reconsidered, 1 INDUS. &AMP; CORP. CHANGE 129, 137 (1992)
. ("The accretion of technological innovations inherited
from the past therefore cannot legitimately be presumed to constitute
socially optimal solutions provided for us--either by heroic entrepreneurs,
or by herds of rational managers operating in efficient markets").

We have defined synchronization to have a
meaning similar to that which the literature has given to the
term compatibility. E.g., Katz & Shapiro, supra
note 5, at 424-425.

Marshall thought that increasing returns was the
norm for production of all goods except agricultural and extraction
goods. However, as Stigler pointed out, Marshall's discussion
of increasing returns indicates that he confused movements along
the cost curves with movement of the cost curves. George J. Stigler,
PRODUCTION AND DISTRIBUTION THEORIES 68-76 (1941). See also
H.S. Ellis & W. Fellner, External Economies and Diseconomies,
33 AM. ECON. REV. 493 (1943). Some modern authors have made the
same claim, almost precisely echoing Marshall. E.g. W.
Brian Arthur, supra note 9. .

It is possible, and perhaps likely, that the competition
between VHS and Beta enhanced the speed of innovation, as the
formats fought for market leadership. Increased recording time,
hi-fi sound, wireless remote controls, increased picture resolution,
etc. all came about very quickly, with each format striving to
keep ahead of the other. We are somewhat surprised that there
are only few, if any, suggestions that competition between formats
might be beneficial in the same way as competition between producers.
Dennis W. Carlton & J. Mark Klamer, The Need For Coordination
Among Firms, With Special Reference To Network Industries,
50 U. CHI. L. REV. 446 (1983) (illustrates the traditional view
of a tradeoff between competition and efficiency).

If there were production economies at the firm level,
we should see many natural and entrenched monopolies. Many early
leaders of new technology industries are not those who now dominate
their industries - e.g. Sony's videorecorder Betamax, Digital
Research's operating system (CPM), VisiCalc's spreadsheet standard,
Lotus 1-2-3 (which appears to be losing to Excel), and so forth.

Although it may appear that we are modeling consumer
behavior only with respect to the purchase flow, the impact of
stocks will be added into the model later. A somewhat more general
mathematical model based on both stocks and flows gives the same
basic results. S.J. Liebowitz & Stephen E. Margolis, Don't
Handcuff Technology, __ UPSIDE __ (September 1995).

We assume that all members in the network are equally
likely to interact with another user. If some members of the network
were more important than others (i.e. greater likelihood of interaction),
the overall share would be less essential than shares weighted
by the importance of members in the network.

Of course, for any consumer, the two net value curves
need not have the same sign. Moreover, different consumers need
not have the same signs on their net value curves. In the latter
case, there would be a group of customers with density functions
like figure 4, and another group with density function like figure
5. The overall density function would be a mixture of these two.
In the former case, if one format had a positive sloping (with
respect to market share) net value curve, and the other a downward
sloping net value curve, the relative size of the slopes in absolute
terms would decide whether the result was a mixed-share, or a
either-or equilibrium. If the upward-sloping curve were steeper
than the downward sloping curve, the result is identical to the
case in which both curves are upward-sloping, and the either-or
result prevails. If the upward-sloping curve is less steep, the
results are the same as when both are downward sloping, and a
mixed-share equilibrium would prevail.

Even here we shouldn't let ourselves be seduced by
the natural monopoly story. Yes, the (large ) fixed costs imply
an element of natural monopoly, but after millions of copies have
been sold, how steep is the slope of the average fixed cost curve?
We suspect that for many software products, the fixed costs are
overwhelmed by variable costs.

This discussion invokes the usual assumption that
the supply function does not reflect a real or technological externality.

One possible consequence of internalizing the synchronization
effect occurs when the sign of the slope of the social net value
function is different from the sign of the slope of the private
net value function. Since the social net value function must have
a larger slope than the private net value function, this change
in sign can only occur when the private net value function is
downward sloping, and the social net value function upward-sloping.
In this case, the private net value function implies a mixed-share
equilibrium, but the social net value function with an either-or
equilibrium would result if the externality were internalized.

In fact, when VHS came to the US market, largely
under the RCA brand, it significantly undercut the price of Beta
although Beta almost immediately matched the price cut. James Lardner, Fast Forward, 1987 W.W. Norton, New York,
page 164.

In fact, both VHS and Beta, aware of the need to
generate market share, allowed other firms to put their brands
on videorecorders. This was the first time that Sony was willing
to allow another firm to put its name on a Sony produced product.
Page 159 James Lardner, Fast Forward.

It reached above six billion dollars although the
company had virtually no profits and very small sales. Standard
and Poor's Stock Guide, McGraw-Hill, 1996 indicates that there
were approximately thirty eight million shares that reached a
price of $140 per share.

Present day keyboard machines may be converted to
the simplified Dvorak keyboard in local typewriter shops. "It
is now available on any typewriter. And it costs as little as
$5 to convert a Standard to a simplified keyboard." ARTHUR
T. FOULKE, MR. TYPEWRITER: A BIOGRAPHY OF CHRISTOPHER LATHAM SHOLES
160 (1961).

PAUL R. KRUGMAN, PEDDLING PROSPERITY: ECONOMIC SENSE
AND NONSENSE IN THE AGE OF DIMINISHING EXPECTATIONS (1994).

David, Clio and the Economics of QWERTY
supranote 33 at 332

DIVISION OF SHORE ESTABLISHMENT &AMP; CIVILIAN PERSONNEL,
NAVY DEPARTMENT, Navy Department Practical Experiment in Simplified
Keyboard Retraining: A Report on the Retraining of Fourteen Standard
Keyboard Typists on the Simplified Keyboard and a Comparison of
Typist Improvement from Training on the Standard Keyboard and
Retraining on the Simplified Keyboard (July 1944) (Oct. 1944).

For a full discussion of the use of
this example in academic and other writings, see our forthcoming
article in Reason, (forthcoming) June 1996. For use in
one of the seminal papers on network externality, see Michael
Katz and Carl Shapiro, 94 J. Political Econ. 4 (1986) 822. For
one of his frequent uses of QWERTY, see W. Brian Arthur, Positive
Feedbacks in the Economysupranote 9. Also see Paul
Krugman, Peddling Prosperity supranote 34 and Gary L. Reback
et al., Why Microsoft Must Be Stopped supranote 1